Strategies for Bond Buyers

08/26/2005 12:00 am EST

Focus:

Alexandra Lebenthal

President, Lebenthal--A Division of Advest, Inc.

"Investing is part science, and we can provide numbers and rates of return based on the past," says Alexandra Lebenthal. "But it's also emotional, and what goes on in our heads and hearts can be even more important." Here, the bond expert offers her strategic advice.

"Let's look at interest rates over the last six years. For those who were in the bond market in 1999, it was a very unpleasant year in the fixed-income market. Interest rates were going up, and the value of bonds was going down. Then, following the Nasdaq crash, interest rates started to go down with a vengeance, ending at historic lows. Then over the last year we've seen short-term interest rates go up in very measured 25 basis point interest rate increases. In fact, as of last year, everyone absolutely knew that rates were going up.

"However, here we are with much higher short-term rates while long-term interest rates are actually lower than they have been over the last several years - and that is the Fed's conundrum. But what a lot of people don't realize is that the only thing that Greenspan controls is short-term rates. He has nothing to do with long-term rates. That's something that we, as investors, control. So we're at a point where there is a lot of uncertainty and a lot of questions about what might happen.

"Here are some things that everybody should think about as they are looking at their interest rate forecast. First, understand that bonds move when interest rates move. This is like a seesaw. When prices go up, yields go down, and visa versa. But there are also different things that can make a bond move, most notably is its maturity, which is the length of time that a bond has to go until it matures. Now a lot of people who buy bonds don't actually care that the value of the bond is going up or down, as long as they know they will be getting their interest every six months and that they will get their money back at maturity. On the other hand, many people do care, because they may need their money back sooner than when the bond matures.

"There are many things going on right now that impact bond prices. The price of oil is in the newspapers every day. You can see this in the price it costs to fill up your SUV. But think about what this does if you are in an industry that depends upon oil. Think about the airlines, which weren't doing well to begin with, now having to deal with the ever-increasing cost of oil. Personally, I live in New York City, and I am staggered by the cost of real estate. In fact, this reminds me of NASDAQ at 5000 and the belief that prices were never going to go down. I do believe that over the next year we will begin to see pricks in the real estate bubble.

"And then there is inflation. This is always one of the most important things that the Fed has to consider, as the cost of goods go up, then that has a great impact on the economy. We also need to consider the yield curve. Right now, the yield curve is very flat. Indeed it is almost inverted, which would mean that short-term rates were higher than long-term rates. In nine out of the past ten times when interest rates have inverted, it has meant that a recession was coming in the subsequent six months. There are times when the yield curve is very steep, which tells you to buy long-term bonds because you are getting much better value in exchange for going out that far. If the yield curve is flatter, why buy long-term bonds if you can get almost the same yield from a shorter-term bond?

"So how do you think about all these factors to determine what to do with your portfolio? To me, in terms of strategy, what you actually want to do is hedge your bets with some short-term bonds and some long-term bonds. One strategy is to stay in short-term rates. Put your money in a money market and just wait until we've reached a point that interest rates are high. And then buy bonds. However, you must be aware of the income you will give up by staying in low-yielding, short-term instruments.

"Another strategy is to create a portfolio ladder. To me, this is one of the best, simplest, and most straightforward ways to invest in bonds. It also gives you a certain amount of discipline in terms of managing your portfolio on an ongoing basis. A bond ladder is exactly what it sounds like. You have rungs on a ladder and each run represents a different length of maturity. For example, you can have a bond ladder that stretches from ten to 20 years, with your holdings divided into different maturities or rungs on that ladder.

"So what do you do when you get to the top of the ladder? When the lowest maturity bonds come due, in this example, the ten-year Treasuries, you simply take the proceeds and buy new bonds with maturities above the highest rung on the ladder. Doing this gives you discipline because when money comes due, you reinvest those funds in longer-term maturities. It's a very methodical strategy. In this example, the average coupon on the laddered portfolio would be 4.84%.

"Another example would be a laddered bond portfolio ranging from five to 25 years. And there is another type of ladder strategy you can use which is to have half of your portfolio short and half long. In this case, you just take out the middle rungs. We call that a barbell portfolio. What that does for you is provide a little more stability, as the first half will all come due within five years. At the same time, you also have the benefit of the higher income from the longer-term bonds.

"If you want to be a little more aggressive, you can invest in closed-end bond funds. In a closed-end fund, there is a fixed portfolio of bonds put together by managers. They come out in an initial offering. Once it's done with its offering, you can then buy it on the exchange similar to buying a stock. If you believe that long-term rates are going up, then now is not the time to be buying closed-end funds. Personally, I take the bond interest that is coming in from my bonds every six months, and use that to buy closed-end funds. That forces me to dollar cost average. I don't look at the statements and don't care about the interim fluctuations, because I know that ultimately the bonds in these closed-end portfolios are going to mature.

"My favorite strategy involves what is called cushion bonds. Aside from just staying in short-term issues, cushion bonds are the most effective and conservative strategy as interest rates go up. As an example, I would highlight bonds with a 5% coupon that were issued in 2003 by the DC Water and Sewer District. The longest bond in the series was the 30-year, maturing in 2033. They put a ten-year call date on the bonds. Now, we don't know what will happen, but we do know they are now paying 5% in an environment when bonds with similar maturities are paying 4.6%. So they are likely thinking that they can pay off all the 5% bondholders and then pay a lower rate on new bonds. If that happens, then the original bond will be called pre-refunded.

"If I bought this bond today, I would pay $104.09 or a $4.09 premium above par. If the issue were called in 2013 at 100 cents on the dollar, the worst-case yield to call would be 4.35%. If it goes all the way to 2033, the return will be 4.71%. This call date acts as a cushion. When traders are pricing this bond, they have to price in the likelihood that the bonds will be called. So, the bond is going to fluctuate more like a short-term bond than a long-term bond. So if long-term interest rates are going up in the next several months or years, then this is the type of bond to buy. Just tell your advisor that you want cushion bonds; they should easily be able to have their bond trading departments provide you with a list of issues that meet these criteria."

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